‘Cost-Plus’ Costs
Entrenched expectations that cost increases can and should be passed on are precisely what tight monetary policy is leaning against, but only indirectly.
- The recent tendency of some firms to bundle into prices card-acceptance costs that had previously been surcharged – and then some, in some cases – demonstrates a ‘cost-plus’ approach to pricing. To the extent they can pass on these costs through to prices, it suggests that demand was strong enough to bear it. The RBA will take this as a signal that demand is still outstripping supply.
- This is mostly a story about non-labour costs. Base wages growth has been moderate for some years, though the above-average increase in award wages this year will add a little. Not all firms will seek to pass these cost increases on, but some will, including because they have limited scope to absorb the cost increase into margins.
- A cost-plus mentality has drawbacks, including that it limits the imagination away from finding alternative, efficiency-improving responses. It also accords with recent academic research suggesting that firms form expectations and set prices according to what is happening in their own industry and experience, while putting little weight on economy-wide inflation or central bank credibility. This is an unpleasant message for many consumers or anyone in an interest-sensitive sector when supply shocks abound.
The recent banning of card surcharges has caused considerable upset this month, even though it is a reversion to historical and international practice. The card schemes used to impose “no-surcharge” rules, until the RBA banned these in 2003, and many other countries still have them. The turnaround represents the RBA throwing in the towel on its longstanding effort to use price incentives to get people to choose low-cost payment methods. Surcharges no longer made sense in a largely cashless economy. In any case, least-cost routing puts the power to choose lower-cost methods in the hands of the merchants who actually bear the cost.
In most cases, firms will simply roll the surcharge into the sticker price, leaving the total cost to the consumer unchanged, just more transparent. We also understand that some large retailers have absorbed the cost – if they were surcharging in the first place, which many did not. (The RBA estimated that around 16% of businesses imposed surcharges.) Inevitably, though, some firms have lifted their prices by more than any reasonable estimate of the merchant service fee that the surcharge was meant to cover. And because this is Australia, of course takeaway coffee has been the centre of consumer discontent.
Higher prices for one’s caffeine fix was unlikely to be the main instigator of this month’s slump in consumer sentiment. Petrol prices are typically more salient for cost-of-living concerns, and the before-and-after picture on the RBA announcement that week shows that higher interest rates also contributed to the decline.
In some senses, though, the post-surcharge prices and the RBA’s decisions are linked: businesses passing on increased costs into their own prices – and expecting to be able to make that increase stick – is exactly the kind of inflationary environment the RBA is leaning against. Firms have been subjected to an array of non-labour cost escalations, from pandemic-era supply chain issues to electricity to fuel to water to building supplies. And IT equipment prices, which for decades were a reliable source of cost reductions, are nowadays flat to up. Passing these costs on, leaving margins intact, demonstrates that demand is not weak enough to prevent this, and signals that firms’ inflationary expectations might be higher than the RBA desires. The RBA will take this as a sign that demand is still outstripping supply.
This is mostly a story about non-labour costs. While the Fair Work Commission did hand down an above-average increase in award wages this year and this was probably passed through to prices in hospitality and other labour-intensive sectors, base wages growth has been moderate for some years. Business surveys point to non-labour cost escalation being the real issue lately. This is why we were puzzled by the passage in the RBA minutes this week suggesting that cost pressures reported in business surveys might imply that the unemployment rate consistent with inflation at target (the NAIRU) has risen. It is a convenient belief, though, if unemployment is starting to overshoot your forecasts, as the latest labour market data have done compared with the RBA’s August forecasts.
Not all firms can pass on cost increases. Most small firms do not have the market power, though coffee may be an exception because convenience induces a kind of local market power. And as noted above, large firms with everyday-low-price strategies will instead try to find savings elsewhere in the supply chain.
Still, some firms will seek to pass these cost increases on. Some observers might see this as corporate greed, but another way to frame this strategy is simply as a ‘cost-plus’ mentality. It turns out that cost-plus pricing is especially common in areas where regulators determine the price – water and other utilities being examples where costs and prices have escalated a lot in recent years.
There are limits to firms’ ability to absorb costs, too. The failures of so many building firms a few years ago, squeezed between post-pandemic cost escalation, delivery delays and fixed-price contracts, were a case in point. Normally, there is a contractual response, and it need not end in insolvency. The episode does illustrate, however, that it is unrealistic to expect firms never to pass cost increases through to prices.
The cost-plus mentality does have its drawbacks. It limits the imagination away from finding responses that might save costs elsewhere to absorb the cost hike, and in so doing, boost efficiency. It was equally limiting in times of soft demand: in the years before the pandemic, many firms professed a belief that, because they couldn’t get price increases to stick, they could not possibly accept cost increases, including in wages. Thus, Australia ended up with wages growth too low to be consistent with inflation at target, and the peculiar spectacle of a central bank governor complaining that wages growth was too low. And if labour remains cheap, why invest to economise on it and thereby boost productivity?
A cost-plus mentality also amplifies the pass-through of supply shocks. This is not quite the same thing as the ‘inflation expectations’ seen in standard economic models of inflation, but it is related. The stronger the tendency towards cost-plus pricing, the worse the inflation response to a supply shock. This is also true when inflation expectations are high, but the distinction matters. The recent academic literature includes some fascinating empirical evidence from New Zealand that suggests that beliefs about current and future overall inflation have little bearing on many firms’ pricing decisions. As related work using French data shows, firms’ pricing choices are shaped less by economy-wide inflation developments than by what is happening to their costs and in their industry.
That adds up to economy-wide behaviour that looks a lot like firms (in aggregate) setting prices according to expected inflation (in aggregate), but under the hood something quite different is going on. If firms’ beliefs about future economy-wide inflation do not matter much in their pricing decisions, then neither does the credibility of a central bank’s commitment to return inflation to target. The mechanism to get inflation down then must be simply to weaken demand enough to convince firms that cost-plus will not fly in the market. This is an unpleasant message for many consumers or anyone in an interest-sensitive sector when supply shocks abound. It does, however, imply that if supply shocks fade or even self-correct, so will high inflation. If and when that happens, tight monetary policy can be unwound.
The deeper question is whether cost-plus price dynamics can be reduced. That is more likely to be a question for regulators than for central banks.
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Australia and NZ Weekly 12 October 2026
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